EXPOSURE DRAFT. The members of the work group that are responsible for this practice note are as follows:

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1 EXPOSURE DRAFT Practice Note on Anticipated Common Practices Relating to AICPA Statement of Position (SOP) 05-1: Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts The American Academy of Actuaries is a national organization formed in 1965 to bring together, in a single entity, actuaries of all specializations within the United States. A major purpose of the Academy is to act as a public information organization for the profession. Academy committees, task forces and work groups regularly prepare testimony and provide information to Congress and senior federal policy-makers, comment on proposed federal and state regulations, and work closely with the National Association of Insurance Commissioners and state officials on issues related to insurance, pensions and other forms of risk financing. The Academy establishes qualification standards for the actuarial profession in the United States and supports two independent boards. The Actuarial Standards Board promulgates standards of practice for the profession, and the Actuarial Board for Counseling and Discipline helps to ensure high standards of professional conduct are met. The Academy also supports the Joint Committee for the Code of Professional Conduct, which develops standards of conduct for the U.S. actuarial profession. This practice note was prepared by the Life Financial Reporting Committee of the American Academy of Actuaries. The Academy welcomes your comments and suggestions for additional questions to be addressed by this practice note. Please address all communications to Tina Getachew, Risk Management and Financial Reporting Policy Analyst at getachew@actuary.org. The members of the work group that are responsible for this practice note are as follows: Errol Cramer, FSA, MAAA Robert Frasca, FSA, MAAA James Garvin, FSA, MAAA Noel Harewood, FSA, MAAA Patricia Matson, FSA, MAAA John Morris, FSA, MAAA Leonard Reback, FSA, MAAA Darin Zimmerman, FSA, MAAA Page 1 of 30

2 Introduction The practices presented here represent the views of actuaries in industry, consulting and public accounting firms who are involved in implementation of the SOP. The purpose of the practice note is to assist actuaries with application of the SOP. It should be recognized that the information contained in the practice note provides guidance, but is not a definitive statement as to what constitutes generally accepted practice in this area. Actuaries should consider the facts and circumstances specific to their situation, including the views of their independent auditors, in making a determination of appropriate practice. The following accounting documents are referenced in this document. The reader of this document should be familiar with these documents in order to fully understand the effects of the SOP. FAS 60 - Accounting and Reporting by Insurance Enterprises FAS 97 - Accounting and Reporting by Insurance Enterprises for Certain Long Duration Contracts and for Realized Gains and Losses from the Sale of Investments FAS Accounting and Reporting for reinsurance of Short-Duration and Long-Duration Contracts FAS Accounting for Derivative Instruments and Hedging Activities SOP Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long Duration Contracts and for Separate Accounts EITF Accounting for the present Value of Future Profits Resulting from the Acquisition of a Life Insurance Company AICPA Technical Practice Aid Reinsurance This practice note has been divided into six sections: Section A: Definition of internal replacement and scope as per paragraphs 8, 9 and 10 Section B: Integrated/nonintegrated issues as per paragraphs 11 and 12 Section C: Determining substantial changes issues as per paragraph 15 Section D: Accounting for contracts that are substantially unchanged as per paragraphs 16 to 24 Section E: Other issues Section F: Examples Page 2 of 30

3 As of the date this Practice Note was published, a number of SOP 05-1 implementation issues were being discussed by the AICPA's Insurance Expert Panel. At this time, the Expert Panel has not issued any additional clarifying guidance on these issues. Therefore, if and when the Expert Panel provides additional guidance, some comments in this Practice Note may need to be updated. Page 3 of 30

4 Section A: Definition of internal replacement and scope as per paragraphs 8, 9 and 10 All Lines of Business Q1: Does the legal form of a modification affect the accounting under the SOP? For example, should the following two situations be treated the same for purposes of applying the SOP: (a) adding additional variable investment options to an existing contract through contract amendment and (b) replacing the contract with a new variable annuity contract where the only difference is additional investment options? A1: Paragraph A4 of the SOP states that the legal form of the modification should not affect the accounting under the SOP. In part, this paragraph says: "Modifications to contract terms can be achieved through a variety of different legal structures and the form of the modification may be a result of company preference and convenience or regulatory constraints. The Accounting Standards Executive Committee (AcSEC) believes that, in concept, the legal form of a modification should not determine the accounting applicable to the transaction and the accounting should be based on the substance of the transaction, regardless of whether it takes the form of an amendment, endorsement, or rider to the contract or the issuance of a new contract in a contract exchange." Q2: How is business assumed via acquisition handled under the SOP? A2: The SOP does not address the initial purchase GAAP but has relevance for accounting for subsequent modifications to the acquired polices. Guidance is provided in footnotes 5, 6 and 7 of the SOP which are identical and state If the replaced contract was acquired in a purchase business combination, any present value of future profits established in accordance with EITF Issue No. 92-9, Accounting for the present Value of Future Profits Resulting from the Acquisition of a Life Insurance Company, should be accounted in a similar manner. Treatment of unamortized balances for present value of future profits (PVP), or equivalently value of business acquired (VOBA), is then analogous to that for deferred acquisition costs (DAC). This is reiterated in paragraph A16, which states further in regard to acquired business paragraphs 16 and 25 of this SOP provide guidance on accounting for other balances associated with the replaced contract. Other balances covered in paragraphs 16 and 25 include reserves arising from SOP 03-1, unearned revenue liability and deferred sales inducement assets. The acquiring company would then account for business acquired through a purchase transaction, regarding unamortized PVP/VOBA and other related asset and liability balances, analogously to how it accounts for directly issued business. Q3: If the purchase GAAP had been set up on a net liability basis, i.e., with no explicit VOBA held, does the SOP apply? A3: Yes. This is addressed in paragraph A16 that states A respondent to the November 2004 exposure draft requested that the SOP specifically address the accounting Page 4 of 30

5 implications when the contract is substantially changed and the value of business acquired (VOBA) is viewed as part of the contract holder liability. AcSEC noted that paragraphs 16 and 25 of this SOP provide guidance on accounting for other balances associated with the replaced contract. The net liability then falls under the SOP. Q4: How is business assumed via reinsurance handled under the SOP? A4: Guidance is provided in paragraph A17 of the SOP as follows AcSEC concluded that the reinsurer has a contract with the ceding company, and that is the contract that the reinsurer should evaluate for modifications. Modifications to a reinsurance treaty would then need to be evaluated by the reinsurer for SOP treatment. Some examples that might arise are as follows: The treaty is amended to include an additional block of inforce. The reinsurer determines the new block to be nonintegrated and establishes DAC for the new block. DAC for the existing block is retained. The ceding company sells its block of business and the treaty is novated to allow the acquiring company to be the new cedant. Other than the change in counterparty, the reinsurer may determine that the treaty terms to be substantially unchanged and DAC is retained. The treaty is amended to reduce the coinsurance percentage on inforce. The reinsurer determines there is a reduction in coverage with proportional reduction in premiums and allowances. DAC is retained and appropriately reduced. The treaty is amended to convert from coinsurance to yearly renewable term (YRT) and assets transferred to the ceding company. The reinsurer determines there is a substantial change in investment risk and the original treaty should be considered to have terminated and the DAC associated with that treaty should be accounted for as any termination would under the appropriate accounting model (e.g., FAS 60, FAS 97). The YRT treaty would be considered as if it were a new treaty and only acquisition expenses associated with this issuance of the new treaty are to be deferred. Q5: For reinsurance assumed, does the reinsurer ever have to consider modifications to the underlying policies (as opposed to modifications to the reinsurance treaty)? A5: Yes. Paragraph A17 states, AcSEC also concluded that while the criteria in this SOP may not be directly applicable to reinsurance contracts, based on the specific facts and circumstances of a transaction, the concepts are useful in evaluating the implications on deferred acquisition costs of modifications to reinsurance contracts or the underlying reinsured contracts. Some potential situations might include the following: The treaty covers YRT on a block of term and universal life (UL) for any excess of death benefit over a retention limit. The reinsurer establishes FAS60 DAC for the Page 5 of 30

6 YRT treaty. A policyholder converts from term to UL of the same face amount. The underlying policy conversion has no bearing on the amount of reinsurance assumed or the YRT reinsurance premiums. There has been no change to the reinsurance treaty. The reinsurer sees no need to look through to the underlying contract conversion and DAC is retained. The treaty covers coinsurance of a block of term and UL. The reinsurer establishes a DAC asset and amortizes it in accordance with FAS 60 for term and with FAS 97 for UL. A policyholder converts from term to UL of the same face amount. The reinsurer writes off a portion of the FAS 60 DAC related to termination of the term policy. The reinsurer does not transfer DAC to the treaty covering the converted UL policy to avoid mixing FAS 60 and FAS 97 accounting. The treaty covers coinsurance of a block of term. A policyholder exercises an option that results in a substantial change where this is done within the original contract and meets the test of paragraph 9 for exemption as an internal exchange. If the treaty contemplates this, i.e., allows for ongoing coinsurance of that contract as a matter of course, the reinsurer might conclude that no internal exchange occurred and DAC is maintained. As a practical matter, the reinsurer simply follows the accounting determination of the ceding company. However, if the treaty requires special consideration such as reinsurer re-underwriting or approval, or adjustment to the coinsurance terms, the reinsurer might conclude this was a substantial change and would then extinguish the DAC. Q6: How is business ceded handled under the SOP? A6: AICPA Technical Practice Aid (TPA) is in regard to SOP 03-1 but has general relevance for reinsurance accounting. The TPA states The accounting for reinsurance should be separate from the accounting for the direct contracts of the ceding company in accordance with paragraphs 14 through 16 of FASB Statement No Accounting on a pre-reinsurance basis then directly follows the SOP. Reinsurance adjustments would include various reserve credits and asset offsets, e.g., contra-dac offset to DAC for up-fronted reinsurance expense allowances. Some guidance is provided by TPA , which states Reinsurance recoverables should be calculated using methods and assumptions consistent with those used to establish the direct contract holder s liability. It appears then that accounting for reinsurance adjustments under the SOP generally would follow modifications to the direct contracts as opposed to modifications to the treaty. It is usually prudent for actuaries to examine the specific facts and circumstances of each transaction to determine the appropriate application of the SOP to reinsurance. Q7: If a policy is terminated and replaced by an affiliate of the original issuer, and the criteria outlined in paragraphs 9 and 10 of the SOP to be considered a replacement are met, how would this be treated under the SOP? Page 6 of 30

7 A7: According to paragraph A.18 of the SOP, there will be intercompany transactions that could produce a different impact for the parent company and the affected affiliates. Assume a policy in Affiliate A was replaced by a policy in Affiliate B. Assume further that the new policy meets the criteria for substantially unchanged with respect to the original policy. From the standpoint of Affiliate A the policy has been extinguished, and Affiliate A s standalone financial statements should reflect that. But from the perspective of the parent company to the two affiliates, there is a substantially unchanged internal replacement, and thus the parent company s financial statements should reflect a continuation of DAC under substantially unchanged accounting. Therefore, the accounting for the transaction at the parent company level may not equal the sum of the accounting as recorded at the affiliate level. When testing for substantially changed in these circumstances, note that if Affiliate B reunderwrites the new policy, there would be a presumption that the new contract is substantially changed. Paragraph A27 of the SOP provides that Reunderwriting the entire contract generally would indicate a substantial change resulting from a change in the kind or degree of mortality, morbidity, or other insurance risk. Q8: If there is no DAC (or DAC-like items such as unearned revenue liabilities or deferred sales inducement assets) on a block of policies or line of business, is there anything in this SOP that would apply? A8: Even though a block of policies may have no DAC or DAC-like items, it is advisable to consider application of SOP 05-1 because it could impact the accounting for subsequent activity on such a block. For example, there may be options or riders that can be elected by the policyholder in the future and generate acquisition costs that would be accounted for under the SOP. Also, even if there is no DAC on the existing block, the classification of the exchange under the SOP would impact the potential deferability of costs associated with the exchange. Further, death benefits or annuitization benefits under SOP 03-1 may be currently so far out of the money as to produce zero reserves, or benefits paid to date may have exceeded the accrued liability, resulting in no current liability. But if future market conditions change, then non-zero SOP 03-1 liabilities may need to be established. The amount of such liabilities may depend on the original classification under SOP 05-1 of the replacement policy. In addition, the SOP guidance needs to be evaluated because, even in the absence of DAC balances, there exists the potential for an impact on recorded liability balances (e.g., GMDB, GMIB, unearned revenue, FAS 60 liabilities). Q9: Paragraph 9 of the SOP defines four criteria for determining whether an election made by a contract holder constitutes an internal replacement. The first of these states that an election must be made in accordance with terms fixed or specified within narrow ranges in the original contract in order for the election not to be deemed an internal replacement. How should narrow range be interpreted in this context? Page 7 of 30

8 A9: The SOP does not explicitly state what a narrow range means. However, by applying the concepts underlying the SOP, one interpretation is that a narrow range is one which would not meaningfully change the nature of the contractual relationship between the insurance company and the contract holder, irrespective of where within that range terms of the contract are set. Paragraph A.7 of the SOP states that the contractual elections must be "... specific enough that the contract holder is able to evaluate whether to elect the feature..." and "narrow enough to provide a meaningful guarantee... A range that is so broad as to enable the insurance company to materially reduce its exposure to a contractual guarantee, or to materially increase the fee it charges for making the guarantee, may not be considered narrow under this interpretation of the guidance. For example, for charges that are expressed as a percent of account value, one could argue that flexibility to alter the charge by more than a few basis points could enable the company to change materially the nature of its guarantee to the policyholder, so a range that exceeds this size (i.e., a few basis points) would not meet the definition of narrow. Similarly, any provision that allows the company to establish the charge for a benefit feature at some future election date rather than guaranteeing it at contract inception would generally not pass this interpretation of "narrow range test. Q10: Is it possible to pass the requirements of paragraphs 9a, 9b and 9c but fail paragraph 9d? A10: Several respondents to exposure drafts of the SOP felt that paragraph 9d is not an independent criterion for determining whether a modification is an internal replacement, but rather a consequence of the other criteria. Without publicly commenting on this point, AcSEC concluded that it was appropriate to retain the paragraph 9d criterion nonetheless. One interpretation would view paragraph 9d s role as adding emphasis to the points established in paragraphs 9a, 9b, and 9c, rather than as an independent criterion. It provides an additional way of thinking about the criteria that may give a clearer route than any of the other three for determining that a contract modification is not an internal replacement. Under this view, it may not be possible to fail the requirements of paragraph 9d without failing at least one of the other three criteria as well. A counterargument to this position is that a contract feature could exist from contract inception without any liability having been established for it. In such a situation, one could argue that the feature was not accounted for since contract inception, as required under paragraph 9d. Others, however, take a broader view of the term accounted for and take it to mean, considered. In this view, a contract feature would have been accounted for since contract inception, as long as it was considered in the establishment of the accounting policy when the contract was written. The example given in the SOP of a feature that escapes FAS 133 treatment because of the grandfathering provision of that Statement seems to support this view. Consequently, if this interpretation is accepted, then a feature that existed and was not "accounted for" at contract inception but otherwise passes the criteria of paragraphs 9a, 9b, and 9c would have been the subject of flawed accounting, because all contract features should have been considered in the establishment of accounting treatment at issue. Page 8 of 30

9 Q11: The SOP glossary defines a contract exchange as The legal extinguishment of one contract and the issuance of another. Does this mean any new issue is automatically an internal replacement if the policyholder had a prior policy with the company which has since been surrendered ( extinguished )? And, if so, how far back would the company need to check? A11: The wording of the SOP implies that the legal extinguishment of one contract and the issuance of another occur simultaneously. In practice, this may not be the case. Contract exchanges include situations where there is an operational time delay between termination of the old contract and issuance of the new contract. There are no specific requirements in the SOP regarding a reasonable time delay. However, where the transactions are not simultaneous, it would appear reasonable to require some evidence of linkage (i.e., that the terms of the replacement contract were fixed and guaranteed at the time that the prior contract was surrendered and that conversion to the replacement contract had been irrevocable) to distinguish an exchange from independent transactions of surrender and new purchase. As a corollary, a company could not choose to merely hold off issuing a replacement contract for a certain time period to avoid treatment as a contract exchange. Q12: How does one distinguish a contract exchange from a surrender of a policy followed by a subsequent unrelated new purchase? A12: Paragraph A4 states the accounting should be based on the substance of the transaction, regardless of whether it takes the form of an amendment, or rider to the contract or the issuance of a new contract in a contract exchange. Where modification to the contract terms is effected by a contract exchange, and could be an alternate to modifying the existing contract or adding a rider, the SOP requires these be treated as internal replacements. It is expected the company would, through its administrative and systems procedures, be able to identify substantially all policies that have been or are in the process of being exchanged. For example, there are statutory policyholder disclosures required for certain contract replacements, and certain tax preferential transfer procedures required (e.g., 1035 exchanges). Q13: Certain reductions in benefits required by state law or regulation are not considered internal exchanges. Does this apply as well to other official directives such as court ordered modifications? A13: Paragraph 10 of the SOP states that partial withdrawals, surrenders, or reductions in coverage are not internal replacements where these occur either by terms as of inception of the contract, or if required by state law or regulation, at terms in effect when the reduction is made. The SOP appears to endorse the concept of substance over form, for example, stating in paragraph A4 that the legal form of a modification should not determine the accounting applicable to the transaction and the accounting should be based on the substance of the transaction. It thus appears that other official directives, for example, federal versus state law, or state bulletin versus state regulation, could be Page 9 of 30

10 equally applied. Other official directives might include court ordered changes such as remedies to policyholders for market misconduct, or court ordered revised benefits under a structured settlement case, or state approval of a health plan rate increase where the company must provide the policyholder the option of paying either the higher premiums or unchanged premiums but with reduced benefits. It would appear important that in all these cases, the terms in effect when the reduction is made should be as set by the official directive and not by the company. Paragraph 10, however, is specific in that it only applies to reductions in coverages. Therefore, it is not clear whether extending this to increases in coverage is appropriate under the SOP. Q14: Under the SOP, how is a modification accounted for if a policy form is altered to account for changes necessitated by regulatory action? For example, what happens if benefits and premiums need to be changed on a Medicare supplement policy because Medicare benefits have changed? A14: This question is relevant only insofar as such a policy has been classified as a longduration policy such that a material asset for deferred acquisition costs is maintained. One interpretation is that the revision of the benefits to comply with new regulation would not constitute a contract modification because of wording contained in paragraph 10. However, this sense is conveyed in a relatively narrow discussion in paragraph 10, which applies specifically to partial withdrawals, surrenders, and reductions in coverage. This could lead to a conclusion that the determinations made under the SOP are independent of the motivation, regulatory or otherwise, that gives rise to them, with the exception of reduced coverages addressed in paragraph 10. Yet another view is that, the relatively narrow applicability of paragraph 10 notwithstanding, changes motivated by regulatory requirements might not constitute internal replacements at all insofar as they can be analogized to guaranteed renewability and/or the implied right within any contract of the regulatory authority to alter its provisions in the interest of public policy. The company should determine if there existed a new negotiation between the company and the policyholder at the time of the change. If so, the transaction would constitute a termination of the old contract and the issuance of a new contract. Annuity Business Q15: Does the addition of a death or living benefit (GMAB or GMWB) to an existing variable annuity contract constitute an internal replacement? A15: This determination can only be made with reference to the specific facts related to the particular product features under consideration. However, adding a GMAB or a GMWB to an existing variable annuity contract under which no such provision existed previously typically would constitute an internal replacement because some or all of the following conditions outlined in paragraph 9 would not have been met: Page 10 of 30

11 - The election is made in accordance with terms fixed or specified within narrow ranges in the original contract - The election of the benefit feature, right, or coverage is not subject to any underwriting - The insurance enterprise cannot decline the coverage or adjust the pricing of the benefit, feature, right, or coverage - The benefit, feature, right, or coverage has been accounted for since the inception of the contract. In order to conclude that the internal replacement resulted in a substantially changed policy, consideration would likely be made as to whether the nature of the investment return rights had been changed as a result of the addition of the living benefit (paragraph 15.b). For a typical GMAB or GMWB that has been added to a variable annuity without such benefit previously, the conclusion that a substantial change has occurred would likely be supported. The examples in paragraphs B.39 to B.41 support this conclusion. Q16: If my company offers a deferred annuity with a death or living benefit that is an elective benefit in the original contract with defined pricing, would election of the benefit be considered an internal replacement? A16: If all of the requirements of paragraph 9 are met, then the election of such a benefit would not constitute an internal replacement subject to the guidance of the SOP. Although there may not have been a value recorded for the benefit prior to election (i.e., because the value has been determined to be zero or immaterial), the benefits should have been accounted for since inception of the contract, thereby satisfying the criterion of paragraph 9d. Q17: Would the election of an annuitization option within a deferred annuity contract result in a change in accounting treatment due to the SOP? A17: Because existing GAAP guidance (e.g., FAS 60 and FAS 97) already requires that an annuitization be treated as a new contract, the SOP would not impact existing accounting. Individual Health Business Q18: How is a rate increase on a guaranteed renewable contract (e.g., long-term care or individual disability income policy) treated under the SOP? A18: So long as the guaranteed renewability feature is clearly established within the contract, a rate increase across an entire class of policyholders does not constitute a contract modification and, consequently, is not an internal replacement subject to the guidance of the SOP. Page 11 of 30

12 Q19: On individual health insurance policies, it is common practice to replace an existing policy with a new policy when a change in benefits is elected by the policyholder. Does this constitute the extinguishment of the initial contract? A19: The SOP appears to ignore the legal form taken by the action (See Q1) and looks to the underlying nature of the insurer-policyholder relationship. Thus the answer to this question depends upon the facts and circumstances of the situation. However, the issuance of a new contract as part of a benefit enhancement does not per se result in the extinguishment of the original contract in the context of the SOP. Q20: On long-term care contracts, a policyholder is often given the option of receiving reduced benefits in return for premium rate stability in the face of a pending premium rate increase. Does acceptance of lower benefits in such a situation constitute a contract modification? A20: As long as the option to receive reduced benefits in exchange for keeping premiums level is provided for in the original contract, election of this option does not constitute a contract modification and the action would not be deemed an internal replacement subject to the provisions of the SOP. If a contractual provision is not present, then the transaction may be deemed an internal replacement. However, paragraph 15c states that a reduction in benefit or coverage does not necessarily mean that a replacement contract is substantially changed, provided that the premium is reduced by an amount commensurate with the reduction in coverage. It is ordinarily prudent to review paragraphs B.21 and B.22 of the SOP in these situations. Group Business Q21: Does the SOP apply to Group business or make a distinction between the individual certificate holder and the group contract holder? A21: The SOP applies to all contracts accounted for under FAS 60 and FAS 97 and therefore does apply to group business. In some circumstances the provisions of the SOP would be applied at group contract level and in other circumstances the provisions of the SOP would be applied at the individual certificate level. According to paragraph A.29 of the SOP, the evaluation of all the related facts and circumstances of a group contract is required to determine whether a contract should be analyzed at the group contract level or individual certificate (under the group contract) level for purposes of applying the guidance in this SOP. Q22: Are rate increases for Group long duration guaranteed renewable business considered within the scope of the SOP? A22: For group long duration guaranteed renewable business, rate increases as allowed under the terms of the contract would not meet the definition of a modification under paragraph 8 of the SOP as long as the rate increase was applied to an entire class of group policyholders and there was no discretion used by the insurance company to adjust the rate for a specific contract. This is consistent with the discussion in paragraph A.25 of the SOP regarding changes in COI rates for universal life type contracts. Similarly, Page 12 of 30

13 changes to premium rates, which are based on a formula specified in the contract and do not involve insurer discretion, would not be considered a modification under the SOP. Premium or benefit changes that involve a judgmental review of the actual experience of the contract holder or the renegotiation of rates or benefits with the contract holder, even if no reunderwriting has occurred, generally would be considered a modification that is subject to the guidance in SOP Section B: Integrated/nonintegrated issues as per paragraphs 11 and 12 All Lines of Business Q23: What is the difference between integrated and nonintegrated features? A23: For long-duration contracts, the SOP defines integrated contract features as those for which the benefits provided by the feature can be determined only in conjunction with the account value or other contract holder balances related to the base contract, and nonintegrated contract features are those for which the determination of benefits provided by the feature is not related to or dependent on the account value or other contract holder balances of the base contract. For many benefit features, these definitions can be clearly applied. However, some transactions may include benefit features that could possibly fit both definitions, while other transactions do not appear to meet either definition. The SOP goes on to say that underwriting and pricing for nonintegrated contract features typically are executed separately from other components of the base contract. It is also typical that nonintegrated benefit features are accounted and/or reserved for separately. Using this information, many actuaries believe that for those transactions where integrated/nonintegrated is not clear, the intent of the SOP is that if there is not separate pricing or reserving of a benefit feature in these situations, it should be considered an integrated benefit feature. If it is not clear whether a particular modification is either integrated or nonintegrated, it should be treated as if it were integrated, which would require analysis under paragraph 15 of the SOP. This is consistent with the flow chart in Appendix C of the SOP. Q24: What are some examples of integrated and nonintegrated benefit features? A24: The most common examples of integrated benefit features are the minimum guaranteed benefits attached to variable annuity contracts, such as guaranteed minimum death benefits and guaranteed minimum withdrawal benefits. Waiver of premium for UL policies, where the benefit is current charges that include cost of insurance charges as opposed to waiving a target premium, is another example of an integrated benefit feature. Nonintegrated benefit features are more numerous. These would include accidental death benefits, term riders, LTC riders and other types of waiver of premium not included in Page 13 of 30

14 the integrated benefit examples above. Q25: Paragraph 11 of the SOP defines nonintegrated contract features as those for which the determination of benefits provided by the feature is not related to or dependent on the account balance or other contract holder balances of the base contract. (emphasis added). What are some examples of other contract holder balances that could affect the classification of integrated benefits versus nonintegrated benefits under paragraph 11 of the SOP? A25: Depending on the structure of the policies in question, other contract holder balances might include the face amount, cash value or death benefit available in the contract. Under some circumstances, the ongoing premium amount specified in the contract would be considered an other contract holder balance under the SOP. Whether or not such premiums are considered to be other contract holder balances would determine whether the addition of a disability waiver of premium rider would be integrated or not. If premiums are fixed in the contract, then it is not likely that adding a benefit based on this fixed schedule would be considered to be integrated. The initial premium amount could also potentially be an other contract holder balance" under certain policy designs where reference is made to the initial deposit for defining certain policy benefits (like minimum return guarantees). The initial deposit may be an other contract holder balance even if the ongoing premium is not considered an other contract holder balance. That is because the initial deposit would have defined the initial account balance in the contract. Whether or not the initial deposit is considered an other contract holder balance would determine whether addition of a benefit that depends on the initial deposit to the contract would be integrated or not. Similar to the above example, if a benefit is added that is based on a fixed amount, even if that amount was originally at the discretion of the policyholder, then it is not likely that this would be considered to be integrated. Q26: What happens if a benefit is added to an existing long-duration health contract and no additional premium is charged for the feature? A26: Typically, the addition of a feature on a long-term care or other health insurance contract would not be integrated with the main contract. Therefore, the original contract could be accounted for as previously, with the new feature accounted for independently as a benefit for which no recurring premium is charged. The fact that the new benefit and the existing benefit are predicated on the occurrence of the same insured event does not imply per se that the benefit features are integrated. If, however, the benefit is considered to be integrated, it would need to be evaluated under paragraph 15. Of course, each situation would have to be reviewed in light of its particular facts and circumstances by consideration of the items listed in paragraph 15. Q27: Is a face amount increase to a UL/VUL contract that is considered to be an internal replacement under the SOP an integrated or nonintegrated feature? Page 14 of 30

15 A27: The example in paragraphs B.7 and B.8 of the SOP are for a face amount increase of an Option A (a.k.a Option 1) type death benefit. Paragraph B.8 indicates that a face amount increase to an Option A death benefit is an integrated feature. There is not an Option B example in the SOP. One conclusion might be that face amount increases to Option B contracts should follow the same accounting as increases to Option A contracts under the rationale that the section 7702 tax death benefit corridor in both Option A and Option B contracts renders both as integrated. Another conclusion would be to consider face amount increases to Option B contracts as nonintegrated because the increased amount is not dependent on the account value of the base contract. In coming to such a conclusion, one consideration might be the integration between the added face amount and the original account balance and face amount resulting from the section 7702 tax death benefit corridor and whether this is material enough to warrant treating the increase as integrated. Section C: Determining substantial changes issues as per paragraph 15 All Lines of Business Q28: Do the requirements of paragraph 15b, regarding a change in the nature of investment return rights, include "degree" of change as change in the insured risk requirements in paragraph 15a? A28: Paragraph 15b does not mention degree or significance of the change in investment return rights. Therefore, a literal reading of the SOP might suggest that no such assessment of degree is necessary with respect to investment return rights. This view holds that certain actions, like the addition of a minimum interest rate guarantee, fundamentally changes the nature of the investment reward rights and therefore should be viewed as a substantial change to the contract without reference to the implied economic value of the change. Paragraph A.30 contains language that might support this view. However, some might argue that the nature of investment return rights is only truly changed to the extent that a material, quantifiable change in the value of those rights has occurred. Others believe that if AcSEC intended a significant component to be part of the requirements of paragraph 15b, that paragraph would have contained a more specific requirement for that test. Q29: Would a change in the guaranteed interest rate on a contract that currently credits a rate in excess of both the original guaranteed rate and the new guaranteed rate result in the contract being classified as substantially changed? A29: There are six criteria that must be satisfied for a contract to be considered substantially unchanged, as outlined in paragraph 15 of the SOP. Paragraph 15b states that the nature of the investment return rights must not have changed. One potential argument under this criterion is that the nature of the investment return rights does not change when one guaranteed minimum interest rate is replaced by another, even though Page 15 of 30

16 the materiality of the guarantee is different. This line of reasoning may lead to a conclusion that the contract is substantially unchanged. A different reading of the term nature, as contemplated in paragraph 15b and discussed in paragraph A.30 of the SOP, is that a change in guaranteed rate needs to be evaluated in order to determine the likelihood of the guarantee coming into play in future crediting rates. If the likelihood that the change in minimum guaranteed rates would significantly affect future crediting rates is remote, then such a modification would not be a substantial change. If the change in minimum crediting rates is likely to affect future crediting rates, then some actuaries believe that the contract now credits interest based on a formula (at least under a material number of potential scenarios), so the nature of the guarantee has changed and the requirements of paragraph 15b are not met. UL/VUL Business Q30: Is the replacement of an Option A contract with an Option B contract (or vice versa) considered a substantial change? A30: Some universal life contracts pay a death benefit equal to the face amount, regardless of the account balance in the contract at the time of death. These contracts are often referred to as Option A or Option 1 universal life contracts. Other contracts pay a death benefit equal to the face amount plus the account balance at the time of death. These contracts are often referred to as Option B or Option 2 universal life contracts. One interpretation is that the replacement of an Option A contract with an Option B contract is an internal replacement under the SOP (unless the provisions of paragraph 9 are met), is an integrated benefit under the SOP, and would be analogous to a face increase. Thus, they believe that this would not constitute a substantial change if only the additional face amount has been underwritten during the contract amendment and if the additional premium charged is not in excess of an amount that would be commensurate with the additional insurance coverage obtained, as outlined in paragraph B.8. Conversely, the replacement of an Option B contract with an Option A contract could be considered a reduction in coverage under paragraph 10 of the SOP. Thus, they would not constitute internal replacements subject to the guidance of the SOP, so long as the modification was allowed by terms that were fixed and specified at contract inception Annuity Business Q31: For a contract that meets the criteria for an internal replacement, in what instances might a reduction in benefits (such as dropping an optional rider) result in the contract being classified as substantially changed? Page 16 of 30

17 A31: There are six criteria that must be satisfied for a contract to be considered substantially unchanged, as outlined in paragraph 15 of the SOP. One of those states that if there is a reduction in benefit, there must be a corresponding reduction in premiums. Otherwise, the change in coverage could result in a substantially changed contract. Also, if the dropping of a rider is considered to change the nature of investment return rights and rewards, the contract could be considered substantially changed even if there is a corresponding reduction in premiums. Note that if the ability to drop the rider is provided within the original terms of the contract, then the policyholder s election to do so would not constitute an internal replacement transaction, rendering the determination of substantially changed vs. substantially unchanged irrelevant. Q32: If an annuity contract has a non-contractual ability to re-initiate the guaranteed rate along with re-initiation of the surrender charge period, would such an election be considered a substantial change? A32: There are six criteria that must be satisfied for a contract to remain substantially unchanged, as outlined in paragraph 15 of the SOP. One of those states that the nature of the investment return rights must not have changed. Some actuaries believe that a change in the underlying guaranteed rate, assuming it is a material change, would result in a substantial change. The comments in Q28 above apply. As described more fully in the answer to Q40 below, re-initiation of the surrender charge period by itself does not result in a substantially changed contract under paragraph 15 of the SOP. Q33: If a variable annuity contract holder with a GMWB rider exchanges the rider for a GMAB rider, would this be considered a substantial change? A33: There are six criteria that must be satisfied for a contract to remain substantially unchanged, as outlined in paragraph 15 of the SOP. One of those states that the nature of the investment return rights must not have changed. One view is that a change from a GMWB to a GMAB is a change in the nature of the investment return rights, and therefore would result in the contract modification being considered a substantial change. Another view is that, because both the GMWB and the GMAB guarantee a minimum return on the account value over a period of time, the nature of the investment return rights has not materially changed and therefore the modification does not constitute a substantial change. A third view similar to this is that as long as the benefits are not significantly different, as measured by actuarial costs or benefit ratios or other appropriate measures, then this type of modification is not a substantial change. The SOP provides an example, which states that replacement of a roll-up GMDB with a ratchet GMDB may not be considered a substantial contract modification. By analogy, one may assume that it is possible to conceive of the replacement of one living benefit guarantee with another under a variable annuity contract as not constituting a substantial change. However, because GMDBs (covered under paragraph 15a) include an element of mortality risk, whereas GMABs and GMWBs (covered under paragraph 15b) typically involve no mortality risk, it ordinarily would not be prudent to extensively rely upon the analogy between GMDBs and these latter two living benefit guarantees. Page 17 of 30

18 Q34: Would the exchange of a contract with a guaranteed minimum death or living benefit that is far out of the money for a contract with no guarantee be considered a substantial change? A34: If the contract holder has the right to drop the coverage under the terms of the contract, the transaction may not be subject to the guidance as described in paragraph 10 of the SOP. There are six criteria that must be satisfied for a contract to remain substantially unchanged, as outlined in paragraph 15 of the SOP. Criterion 15b is that the nature of the investment return rights must not have changed. One interpretation is that a change from a contract with a guarantee even if it is out of the money, to one with no guarantee is a change in the nature of the investment return rights, and therefore would result in a substantial change. However, consideration is typically made as to whether the nature of the investment return rights really changes when the likelihood of a minimum return guarantee paying off is remote, as may be the case under a contract with a guarantee significantly out of the money. Individual Health Business Q35: What if benefits are changed in connection with a rate increase under a guaranteed renewable contract? A35: Please refer to Q20/A20 in this document regarding benefit reductions in lieu of a rate increase. For benefit increases, a determination must be made whether or not such change is within a narrow range allowed under the original contract provisions. If so, then the change in benefits does not constitute a contract modification and the action is not an internal replacement subject to the SOP. On the other hand, if the modification is outside of the range contemplated within the original contract, then the modification would have to be assessed to determine (a) whether it is integrated or nonintegrated with the original contract and (b) if integrated, whether the contract is substantially changed. For individual health policies, one might expect the feature to be nonintegrated because health policies typically do not have benefit features that are a function of contract holder balances. However, each situation would have to be assessed individually depending on the particular facts and circumstances. Group Business Q36: Does the annual (or other periodic) repricing of group business constitute a substantial change in the context of the SOP? A36: See Q22/A22 regarding when a rate increase on a group guaranteed renewable long duration is considered a modification under the SOP. For a premium change on a group long duration contract that is considered to be a modification under the SOP, a Page 18 of 30

19 determination must be made as to whether the repricing/rate reset mechanism under the contract constitutes reunderwriting as contemplated in paragraph 15a. While many believe that the judgmental review of actual experience is a renegotiation of the contract and essentially includes all of the aspects of reunderwriting, the determination of whether "reunderwriting" has occurred has to rely on the specific facts and circumstances of the transaction. Section D: Accounting for contracts that are substantially unchanged as per paragraphs 16 to 24 All Lines of Business Q37: How are deferrable renewal commissions treated on substantially unchanged policies? A37: Renewal commissions on a substantially unchanged policy would be deferrable up to the level that would have been deferred in the original contract according to its original terms, to the extent such commissions meet the deferability requirements of FAS 60 or FAS 97. Any commissions in excess of that amount would have to be expensed as incurred. Paragraph 22 of the SOP states The portion of renewal commissions paid on the replacement contract that meets the criteria for deferral in accordance with the provisions of FASB Statements No. 60 and No. 97, as appropriate, limited to the amount of the future deferrable renewal commissions on the replaced contract that would have met the deferral criteria, continues to be deferrable under the provisions of FASB Statements No. 60 and No. 97 (emphasis added). There is a related issue regarding situations where there was a benefit increase to a policy, and expenses were incurred directly related to the benefit, but despite the benefit increase the modification leaves the original policy substantially unchanged. While literal reading of paragraph 22 of the SOP may be interpreted to imply that the expenses associated with providing the benefit increase should not be deferred, actuaries and accountants believe that paragraph 22 did not intend to limit deferral of the expenses directly related to a benefit increase, and that limiting deferral in this manner can create inappropriate differences in accounting results between similar transactions (for example, increasing the face amount of a UL contract versus purchasing an additional UL contract for the incremental face amount). Costs directly related to a benefit increase remain eligible for deferral. All Lines of Business Section E: Other issues Page 19 of 30